1. Kevin Chow Senior Manager Research Department Hong Kong Monetary Authority 9 October 2015 F INANCING D IFFICULTY OF S MALL F IRMS IN C HINA

2. 2 Why alleviating financing difficulty of small firms is important for China? l Small and Medium-sized Enterprises (SMEs) play a pivotal role in fostering economic growth, creating employment and driving innovations in China. They contributed to  60% of GDP in value-added terms,  50% of tax income and,  more than 70% of new jobs creation l However, credit that small firms can get is hardly matched by their economic significance, and this has become a major obstacle for SMEs to increase investment and expand business l To alleviate financing difficulty of small firms is important for China at this juncture as debt overhang problem in local governments and some state-owned sectors means that private sector investment will play a more important role

3. 3 Financial constraints faced by SMEs: how big is the problem? Sources: CEIC, PBOC and staff estimates. Disproportionate small amount of credit allocated to small firms Proxy of borrowing costs faced by small firms l The phenomenon of financing difficulty in China manifests itself in two aspects 1. Most credit has been allocated to larger firms such as listed companies and state-owned enterprises, little is left for small firms. 2. Small firms tend to pay much higher interest rates than their larger counterparts in borrowing even after controlling for risk profiles

4. 4 Listed company data show small firms tend to face higher borrowing cost than large firms Sources: Listed company data from WIND and staff estimates. l To investigate into the issue, we studied the borrowing costs and funding structure of non-bank corporates listed in A-share market for the period between 2010 – 2013. l Small firms tend to pay interest rates 50 – 100 basis points higher than their larger counterparts, depending on industry they belonged to.

5. 5 The differentials in borrowing cost are more prominent for listed firms with higher leverage, poorer liquidity… Sources: WIND and staff estimates. Leverage – Debt to asset ratios Liquidity – Current assets to total assets l We also compare the borrowing costs between riskier and less risky firms according to their leverage, liquidity and profitability. l It is found that for the riskier firms the borrowing costs differentials due to firm size are more pronounced compared to the less risky firms.

6. 6 …or weaker profitability Sources: WIND and staff estimates. Profitability – Return on assets l We also compare the borrowing costs between riskier and less risky firms according to their leverage, liquidity and profitability. l It is found that for the riskier firms the borrowing costs differentials due to firm size are more pronounced compared to the less risky firms.

7. 7 After controlling for risk profiles, small firms still tend to face higher borrowing cost than large firms within the same industry Sources: WIND and staff estimates. l To test the robustness of our findings, we also performed a regression analysis to control for the three risk factors (i.e., leverage, liquidity and profitability) at the same time. l Holding other variables constant, a 1% increase in firm size on average would reduce a firm’s borrowing costs by 0.41 basis points

8. 8 The root causes of financing difficulty of small firms in China (1) l Information asymmetry on borrowers’ risk profiles between lenders and borrowers. Banks usually require collateral from small firms more than large firms  The lack of tractable history of operations and profits, limited financial information disclosure and inability to provide collateral have put small firms into disadvantage position in getting credits. Sources: WIND and staff estimates.

9. 9 The root causes of financing difficulty of small firms in China (2) l Banking sector in China is dominated by the 4 state-owned commercial banks. They have been able to secure decent profits under the interest rate rules. l They therefore can focus on lending to SOEs or large firms while have little incentive to extend business to lending to small firms. l While financing activities conducted through the shadow banking channel have expanded notably in recent years, they do not replace the dominant role of the traditional banking system Sources: CEIC, PBOC, WIND and staff estimates. Bank loans remain the major source of finance City and rural banks are active in SME lending

10. 10 Policy measures to alleviate financing difficulty of small firms SolutionContents Central credit registry & loan guarantee schemes Effective tool to reduce the problem of information asymmetry Common and well established in many OECD countries Interest rate liberalisation Catalyst for changing the lending behaviour of big banks  Pass on the increase in funding costs to larger firms such as SOEs, thus reduce their loan demand  Narrowing interest margin would prompt banks to seek for better risk return trade-off by lending to small firms Development of a liquid interbank market As a reliable alternative funding source for small banks Ease funding constraints faced by small city and rural banks and they can channel more funds to small firms. Alternative source of finance Private lending / P2P loans ‚Internet banking Stringent risk requirement would be important to safeguard financial stability

11. 11 Conclusion ●There are evidences that small firms tend to pay higher interest rates than larger counterparts, even after controlling for difference in their risk levels. The borrowing cost differential is more pronounced for the group of firms with higher financial risks ●Financing difficulty of small firms in China to a large extend is a structural issue related to its financial market structure and interest rate regulations that hinder real competition in the banking sector ●Policy efforts that reduce information asymmetry, ensure a level-playing field for small and big banks, and introduce more competition to the banking sector would be useful in alleviating financing difficulty faced by small firms